At current levels the market is not only overvalued, but
is ignoring the sputtering U.S. economic recovery, the slowing of earnings
growth, and the prospect of tapering QE in the second half, perhaps as early as
September.The additional prospect of a
stalemate in Washington over the federal budget, the debt ceiling and the
potential shutdown of the government is also being overlooked, not to mention
the serious slowdown in global growth.

Despite unprecedented monetary ease, the economy has
slogged along at an average 2% growth rate over the last three years and seems
to be slowing down even more in 2013.GDP grew at an annualized rate of only 1.1% in the 1st quarter
and 1.7% in the 2nd with final demand even lower at 1.3% and 0.3%
respectively.

The reasons for the lagging growth are not hard to
find.Simply put, there is not enough
demand as consumers continue to deleverage the enormous amount of debt built up
during the housing boom at the same time their incomes are barely rising.For the last 60 years household debt, which
averaged about 77% of real disposable income, soared to 129% at the peak in
2007.While some progress has been made
in reducing the ratio to 106%, it is still a far cry from the 60-year average.

At the same time consumers’ ability to spend is severely
limited.Real spending increased at a
tepid 2% over the past year, and even this amount is unlikely to be maintained
as real disposable income during the period rose only 0.6%.With the household savings rate at a recovery
low of only 4.4%, consumers are unlikely to reduce the rate even more in order
to support spending.

The reported increase in payroll employment is not likely
to change the bleak outlook for income and spending.Monthly job increases have averaged 186,000
over the last two years, far below the amount recorded in prior recoveries.In addition the rate of new jobs has not
picked up recently as average employment rose by an average of only 175,000
over the last three months.

Furthermore, an unusually high proportion of new jobs
were part-time and in lower paying segments such as leisure and hospitality,
where wages are only $13.48 per hour, compared to $24.37 per hour in
manufacturing jobs, which have been going down.And since hours worked per week are much lower in leisure and
hospitality than in manufacturing, the gap in weekly wages between the two segments
is even greater.That is why consumer
incomes are not keeping pace with the increase in jobs.

In sum, we believe that the economy is losing steam
rather than picking up.This is
happening at the same time that the Fed seems intent on paring down QE,
dysfunction is coming to a head in Washington, earnings increases are decelerating,
and global economies are under pressure.Under these circumstances the potential for a severe market decline should
not be overlooked.